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6 - Multivariate models

Published online by Cambridge University Press:  05 June 2012

Chris Brooks
Affiliation:
City University London
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Summary

One of the assumptions of the classical linear regression model is that the explanatory variables are non-stochastic, or fixed in repeated samples. There are various ways of stating this condition, some of which are slightly more or less strict, but all of which have the same broad implication. It could also be stated that all of the variables contained in the X matrix are assumed to be exogenous or that the model is ‘conditioned on’ the variables in X. However, this assumption will be violated when there is feedback from the explained variable to the explanatory variable(s) – in other words, if there is a simultaneous relationship between them. This chapter first considers how to model simultaneous equations using an example on the relationship between inflation and stock returns.

Setting up a system

What is the relationship between inflation and stock returns? Holding stocks is often thought to provide a good hedge against inflation, since the payments to equity holders are not fixed in nominal terms and represent a claim on real assets (unlike the coupons on bonds, for example). However, the majority of empirical studies that have investigated the sign of this relationship have found it to be negative. Various explanations of this puzzling empirical phenomenon have been proposed, including a link through real activity, so that real activity is negatively related to inflation but positively related to stock returns so that stock returns and inflation vary negatively.

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Publisher: Cambridge University Press
Print publication year: 2008

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  • Multivariate models
  • Chris Brooks, City University London
  • Book: RATS Handbook to Accompany Introductory Econometrics for Finance
  • Online publication: 05 June 2012
  • Chapter DOI: https://doi.org/10.1017/CBO9780511814082.007
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  • Multivariate models
  • Chris Brooks, City University London
  • Book: RATS Handbook to Accompany Introductory Econometrics for Finance
  • Online publication: 05 June 2012
  • Chapter DOI: https://doi.org/10.1017/CBO9780511814082.007
Available formats
×

Save book to Google Drive

To save content items to your account, please confirm that you agree to abide by our usage policies. If this is the first time you use this feature, you will be asked to authorise Cambridge Core to connect with your account. Find out more about saving content to Google Drive.

  • Multivariate models
  • Chris Brooks, City University London
  • Book: RATS Handbook to Accompany Introductory Econometrics for Finance
  • Online publication: 05 June 2012
  • Chapter DOI: https://doi.org/10.1017/CBO9780511814082.007
Available formats
×